NAB in search of a capital idea

As the first bank out of the blocks in the annual reporting season,
National Australia Bank
was bound to have the key components of its $4.6 billion cash profit put under a microscope and any weaknesses well amplified.

The earnings quality issues in the generally solid result were the low tax rate, the lower bad debt provision coverage compared with peers, the lower capital position relative to peers, the sharp improvement in its troubled assets fund and the downward pressure on interest margins, particularly in the second half.

But chief executive
Cameron Clyne
was oozing confidence yesterday about the outlook and NAB’s ability to cash in on the strong pipeline of business lending. That confidence was evident in the higher than expected final dividend of 78¢ a share.

Clyne is pushing the business lending opportunity because NAB is the country’s biggest business bank. However, last year the bank got its forecasts of business lending wrong. Instead of credit growth being positive, lending to business was minus 3.5 per cent. But NAB increased market share and lifted business banking profits by 37 per cent to $2.2 billion.

NAB’s economists are tipping 6.5 per cent growth in business credit over the next year. But anecdotal evidence from the big investment banks is that the top 200 companies are cashed up and tentative about investing or launching into deals that require debt funding.

The mining industry has a big capital investment program but
BHP Billiton
and
Rio Tinto
are big enough to avoid the banks, and smarties like Andrew “Twiggy"
Forrest
are going global for funding and using bonds as much as possible.

One of the best charts in the NAB slide pack yesterday showed NAB flat-lining on business lending, with an increase in assets of $1.9 billion between March and August and the market going backwards by $40 billion over the same period.

Clyne’s confidence extends to the retail bank, which this year ended five years of market-share loss in mortgages. NAB has been winning market share in mortgages for the past five months with the lowest standard variable rate of the big four. That strategy squeezed the bank’s retail margins in the second half by 6 basis points to 2.28 per cent.

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It is almost two years since Clyne set out to differentiate NAB as the customer-friendly bank, with lower fees and no annoying exceptional charges. Clyne’s strategy is suited to the heated political situation.

He also wanted to differentiate the bank as the No. 1 player in wealth management through the $6.4 billion takeover of AXA Asia Pacific’s Australian and New Zealand business. Nearly a year after that doomed bid was launched, Clyne is talking up the 33 per cent rise in MLC’s profits to $548 million and claiming “we are No. 1 in most markets anyway".

Clyne’s focus on being the bank with the best reputation is not winning friends in Canberra. Yesterday, NAB bore the brunt of the Liberal Party’s bank bashing campaign led by shadow treasurer
Joe Hockey
, who set a relatively low benchmark for acceptable levels of bank profitability.

He described NAB’s 19 per cent increase in full-year cash earnings to $4.6 billion as “massive" and proof of lack of competition. One wonders what he will say when
Westpac
Banking Corp delivers a 30 per cent increase in net profit to $5.8 billion next week?

NAB’s profit was equal to a 16 per cent return on capital, which is best measured using the tier one capital set by regulators. NAB has the lowest return on capital compared with
Commonwealth Bank of Australia
, 23 per cent; Westpac, 23 per cent and
ANZ Banking Group,
17 per cent, according to Nomura Australia.

Clyne is not happy with the return on capital NAB is earning and wants to lift it closer to 20 per cent. Institutional investors in the bank, including superannuation funds, want the same outcome. Retail investors like the idea of banks earning more on the capital they provide because it will mean higher dividends.

Banks that earn a higher return on capital are given a higher rating by the sharemarket, as can be seen by the simple and universal measure for valuing banks: price to net tangible assets (NTA). NAB’s price to NTA is 1.9 times compared with CBA 3.2 times, Westpac 2.6 times and ANZ 2.3 times, according to Nomura.

Shareholders in major banks have probably not thought about the implications of Australia’s big four banks having their profitability constrained in some way by regulation or through community pressure to lower returns on capital to more acceptable levels.

If CBA, Westpac and ANZ were forced to lower their return on capital to match NAB at 16 per cent, the consequences for their share prices would be horrendous. CBA’s share price would plunge by about 37 per cent and Westpac shares would crash about 30 per cent.

That is one aspect of the bank profitability debate that has not been given much of an airing.

Another weakness in the debate is the assumption that a fall in home mortgage interest rates would bring down the bank’s profitability.

However, mortgages contribute only about 20 to 30 per cent of bank profits. Interest rates on a range of banking products, including lending to small business, would have to drop significantly if profitability were to fall to levels that Hockey and others regard as acceptable.

But if Hockey has a closer look at the NAB results he will realise that a bank that is increasing market share in home lending and business consumes capital. That is a concern because the capital requirements for banks and the liquidity they must hold is undecided, but undoubtedly going to get tougher.

Those capital and liquidity requirements are due to be agreed in the next few months and implemented over the next eight years. NAB will need to build its capital to meet the minimum tier one requirement of 7 per cent. Its problem is that it does not generate as much retained capital as its peers. That’s why it needs to earn a higher return on capital than it now does.

Aquick snapshot of the career of
Toll Holdings
chief executive
Paul Little
is of a man who built a $60 million domestic trucking company listed in 1993 into a $16 billion global trucking and logistics group with operations in 55 countries and with 40,000 staff.

Little’s legacy includes two spin-offs:
Asciano
and
Virgin Blue
. It is fair to add the market cap of those two companies, which is $5.4 billion, to the Little achievement pile.

One topical feature of the Toll international business is its contract in Singapore to supply transport services to the Singaporean defence forces. It involves a range of contracts.

That is the same country that is being pilloried by independent MP
Bob Katter
for being a foreign landlord. At least the Singaporeans have shown a willingness to open their doors to foreign suppliers of goods and services.

Toll’s announcement that Little will be stepping down in late 2011 or early 2012 as the company searches for a new CEO caused a big hit to its share price. The stock fell 6.6 per cent to $6.20. There are two ways to view that fall in the share price. One is to say it shows the concern among investors about the company’s management without the input of Little.

The other view is that, after 25 years of having a strong hand on the tiller by a dominant personality, the company’s balance sheet settings and other strategic positions will be reviewed and result in some negative impact on shareholders.

The second view was being put about yesterday by an investment banker who may well have been trying to grind an axe.

It goes against the reality of the Toll strategic planning. The company’s chairman,
Ray Horsburgh
, said Little’s departure was timely because the board had recently formulated a five-year strategic plan.

That may not help the task of hiring a new CEO. Another possible dampener is the prospect of Little coming back to join the board in two years. That could make for some uncomfortable moments for the new CEO if tough decisions are required.

Little’s experience in building a key infrastructure services company means he is well qualified to opine on the state of Australia’s infrastructure. His view is that Australia’s container movement rates have slipped from world’s best practice to less than world’s best practice at about 30 containers an hour.

Little thinks state governments have not realised there are certain industries, such as container operators, that need to have scale to survive. He says two container operators in each port can make a viable return but anything more than that is barely viable.

Toll shareholders disappointed with the recent returns of the company should not despair, according to Little. He thinks the recent decline in the growth of Toll’s profitability is directly related to the impact of the global financial crisis and is not a fundamental structural change caused by the increased size of the company and the maturity of markets in which it operates.